Paper F9

Fundamentals Level – Skills Module

Financial Management
Friday 6 June 2014

Time allowed
Reading and planning: 15 minutes
Writing: 3 hours

ALL FOUR questions are compulsory and MUST be attempted.

Formulae Sheet, Present Value and Annuity Tables are on

pages 6, 7 and 8.

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

ALL FOUR questions are compulsory and MUST be attempted

1 The Board of OAP Co has decided to limit investment funds to $10 million for the next year and is preparing its capital
budget. The company is considering five projects, as follows:
Initial investment Net present value
Project A $2,500,000 $1,000,000
Project B $2,200,000 $1,550,000
Project C $2,600,000 $1,350,000
Project D $1,900,000 $1,500,000
Project E $5,000,000 To be calculated
All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects B and D are mutually
exclusive. All net present values are in nominal, after-tax terms.
Project E
This is a strategically important project which the Board of OAP Co have decided must be undertaken in order for the
company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows
of this project is as follows:
Year 1 2 3 4
Sales volume (units) 12,000 13,000 10,000 10,000
Selling price ($/unit) 450 475 500 570
Variable cost ($/unit) 260 280 295 320
Fixed costs ($000) 750 750 750 750
These forecasts are before taking account of selling price inflation of 5·0% per year, variable cost inflation of 6·0%
per year and fixed cost inflation of 3·5% per year. The fixed costs are incremental fixed costs which are associated
with Project E. At the end of four years, machinery from the project will be sold for scrap with a value of $400,000.
Tax allowable depreciation on the initial investment cost of Project E is available on a 25% reducing balance basis
and OAP Co pays corporation tax of 28% per year, one year in arrears. A balancing charge or allowance is available
at the end of the fourth year of operation.
OAP Co has a nominal after-tax cost of capital of 13% per year.

Required:
(a) Calculate the nominal after-tax net present value of Project E and comment on the financial acceptability of
this project. (14 marks)

(b) Calculate the maximum net present value which can be obtained from investing the fund of $10 million,
assuming here that the nominal after-tax NPV of Project E is zero. (5 marks)

(c) Discuss the reasons why the Board of OAP Co may have decided to limit investment funds for the next year.
(6 marks)

(25 marks)

2
2 The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:
$000 $000
Inventory 5,700
Trade receivables 6,575 12,275
––––––
Trade payables 2,137
Overdraft 4,682 6,819
–––––– –––––––
Net current assets 5,456
–––––––
For the year to end of March 2014, CSZ Co had domestic and foreign sales of $40 million, all on credit, while cost
of sales was $26 million. Trade payables related to both domestic and foreign suppliers.
For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at $40 million while cost of
sales will fall to 60% of sales. The company expects current assets to consist of inventory and trade receivables, and
current liabilities to consist of trade payables and the company’s overdraft.
CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 2015:
Inventory days: 60 days
Trade receivables days: 75 days
Trade payables days: 55 days
Current ratio: 1·4 times

Required:
(a) Calculate the working capital cycle (cash collection cycle) of CSZ Co at the end of March 2014 and discuss
whether a working capital cycle should be positive or negative. (6 marks)

(b) Calculate the target quick ratio (acid test ratio) and the target ratio of sales to net working capital of CSZ Co
at the end of March 2015. (5 marks)

(c) Analyse and compare the current asset and current liability positions for March 2014 and March 2015, and
discuss how the working capital financing policy of CSZ Co would have changed. (8 marks)

(d) Briefly discuss THREE internal methods which could be used by CSZ Co to manage foreign currency
transaction risk arising from its continuing business activities. (6 marks)

(25 marks)

3 [P.T.O.
3 The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares. The market value of each
ordinary share is $7·50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which
will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest
on the bonds has just been paid and the current market value of each bond is $107·14.
Fence Co plans to invest in a project which is different to its existing business operations and has identified a company
in the same business area as the project, Hex Co. The equity beta of Hex Co is 1·2 and the company has an equity
market value of $54 million. The market value of the debt of Hex Co is $12 million.
The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies
pay corporation tax at a rate of 20% per year.

Required:
(a) Calculate the current weighted average cost of capital of Fence Co. (7 marks)

(b) Calculate a cost of equity which could be used in appraising the new project. (4 marks)

(c) Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital
asset pricing model. (6 marks)

(d) Discuss the differences between weak form, semi-strong form and strong form capital market efficiency, and
discuss the significance of the efficient market hypothesis (EMH) for the financial manager. (8 marks)

(25 marks)

4
4 The following financial information relates to MFZ Co, a listed company:
Year 2014 2013 2012
Profit before interest and tax ($m) 18·3 17·7 17·1
Profit after tax ($m) 12·8 12·4 12·0
Dividends ($m) 5·1 5·1 4·8
Equity market value ($m) 56·4 55·2 54·0
MFZ Co has 12 million ordinary shares in issue and has not issued any new shares in the period under review. The
company is financed entirely by equity, and is considering investing $9·2 million of new finance in order to expand
existing business operations. This new finance could be either long-term debt finance or new equity via a rights issue.
The rights issue price would be at a 20% discount to the current share price. Issue costs of $200,000 would have
to be met from the cash raised, whether the new finance was equity or debt.
The annual report of MFZ Co states that the company has three financial objectives:
Objective 1: To achieve growth in profit before interest and tax of 4% per year
Objective 2: To achieve growth in earnings per share of 3·5% per year
Objective 3: To achieve total shareholder return of 5% per year
MFZ Co has a cost of equity of 12% per year.

Required:
(a) Analyse and discuss the extent to which MFZ Co has achieved each of its stated objectives. (7 marks)

(b) Calculate the total equity market value of MFZ Co for 2014 using the dividend growth model and briefly
discuss why the dividend growth model value may differ from the current equity market value. (5 marks)

(c) Calculate the theoretical ex rights price per share for the proposed rights issue. (5 marks)

(d) Discuss the sources and characteristics of long-term debt finance which may be available to MFZ Co.
(8 marks)

(25 marks)

5 [P.T.O.
 Formulae Sheet

Economic order quantity

2C0D
=
Ch

Miller–Orr Model

1
Return point = Lower limit + ( × spread)
3
1
 3 × transaction cost × variance of cash flows  3
Spread = 3  4 
 interest rate 
 

The Capital Asset Pricing Model

() (( ) )
E ri = R f + βi E rm – Rf

The asset beta formula

βa =

 Ve
 

βe +  Vd 1 – T 
βd 
( )

(V
 e + Vd
1(– T ))
 
V
  e + Vd
1 – T ( 
 ( ))
The Growth Model

Po =
(
D0 1 + g )
(re
–g )
Gordon’s growth approximation

g = bre

The weighted average cost of capital

 V   V 
WACC =  e  ke + 
 Ve + Vd 
d k 1– T
 Ve + Vd  d
( )
The Fisher formula

(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity

S1 = S0 ×
(1 + h )c
F0 = S0 ×
(1 + i ) c

(1 + h )b (1 + i ) b

6
 Present Value Table

Present value of 1 i.e. (1 + r)–n

Where r = discount rate
n = number of periods until payment

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

7 [P.T.O.
 Annuity Table

– (1 + r)–n
Present value of an annuity of 1 i.e. 1————––
r

Where r = discount rate

n = number of periods

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

End of Question Paper

8
Answers
Fundamentals Level – Skills Module, Paper F9
Financial Management June 2014 Answers

1 (a) Calculation of NPV

Year 1 2 3 4 5
$000 $000 $000 $000 $000
Sales income 5,670 6,808 5,788 6,928
Variable cost (3,307) (4,090) (3,514) (4,040)
–––––– –––––– –––––– ––––––
Contribution 2,363 2,718 2,274 2,888
Fixed cost (776) (803) (832) (861)
–––––– –––––– –––––– ––––––
Cash flow before tax 1,587 1,915 1,442 2,027
Tax at 28% (444) (536) (404) (568)
Depreciation tax benefit 350 263 197 479
–––––– –––––– –––––– –––––– ––––––
Cash flow after tax 1,587 1,821 1,169 1,820 (89)
Scrap value 400
–––––– –––––– –––––– –––––– ––––––
Net cash flow 1,587 1,821 1,169 2,220 (89)
Discount at 13% 0·885 0·783 0·693 0·613 0·543
–––––– –––––– –––––– –––––– ––––––
Present values 1,405 1,426 810 1,361 (48)
–––––– –––––– –––––– –––––– ––––––
$000
Sum of present values 4,954
Initial investment 5,000
––––––
Net present value (46)
––––––
Although the NPV of the project is negative and so financially it is not acceptable, the Board of OAP Co have decided that it
must be undertaken as it strategically important.
Workings
Year 1 2 3 4
Selling price ($/unit) 450 475 500 570
Inflated selling price ($/unit) 472·50 523·69 578·81 692·84
Sales volume (units/year) 12,000 13,000 10,000 10,000
Sales income ($000/year) 5,670 6,808 5,788 6,928
Year 1 2 3 4
Variable cost ($/unit) 260 280 295 320
Inflated variable cost ($/unit) 275·60 314·61 351·35 403·99
Sales volume (units/year) 12,000 13,000 10,000 10,000
Variable cost ($000/year) 3,307 4,090 3,514 4,040
Year Tax allowable depreciation Tax benefit
1 5,000,000 x 0·25 = $1,250,000 1,250,000 x 0·28 = $350,000
2 3,750,000 x 0·25 = $937,500 937,500 x 0·28 = $262,500
3 2,812,500 x 0·25 = $703,125 703,125 x 0·28 = $196,875
4 1,709,375* 1,709,375 x 0·28 = $478,625
*5,000,000 – 1,250,000 – 937,500 – 703,125 – 400,000
Alternative calculation of cash flow after tax
Year 1 2 3 4 5
$000 $000 $000 $000 $000
Cash flow before tax 1,587 1,915 1,442 2,027
Tax allowable depreciation (1,250) (937·5) (703) (1,709)
–––––– –––––– –––––– ––––––
Taxable profit 337 977·5 739 318
Tax at 28% (94) (274) (207) (89)
Tax allowable depreciation 1,250 937·5 703 1,709
–––––– –––––– –––––– –––––– ––––––
Cash flow after tax 1,587 1,821 1,168 1,820 (89)

11
 (b) Calculation of maximum NPV
Project A B C D E
Investment ($000) 2,500 2,200 2,600 1,900 5,000
NPV ($000) 1,000 1,550 1,350 1,500 nil
–––––– –––––– –––––– –––––– ––––––
PV of future cash flows 3,500 3,750 3,950 3,400 5,000
Profitability index 1·400 1·705 1·519 1·789 1·000
Ranking 4 3 2 1
Project E has been ranked first as it must be undertaken. Project B cannot be undertaken if Project D is undertaken, as the
two projects are mutually exclusive.
Calculation of maximum NPV
Investment NPV
($000) ($000)
Project E 5,000 nil
Project D 1,900 1,500
Project C 2,600 1,350
Project A 500 200
––––––– ––––––
10,000 3,050
––––––– ––––––
As Project A is divisible and only $500,000 (20%) of its $2,500,000 initial cost is available after cumulative investment in
Projects E, D and C, the NPV from the project is $200,000 (20% of $1,000,000).

(c) When a company restricts or limits investment funds, it is undertaking ‘soft’ or internal capital rationing. Capital rationing
means that a company is unable to invest in all projects with a positive net present value and hence it is not acting to
maximise shareholder wealth.
There are several reasons why the Board of OAP Co may have decided to limit investment funds for the next year. It may not
wish to issue new equity finance in order to avoid diluting earning per share. Issuing new equity finance may also increase
the risk of a company’s shares being bought by a potential acquirer, leading to a future takeover bid.
The Board of OAP Co may not wish to issue new debt finance if it wishes to avoid increasing its commitment to fixed interest
payments. This could be because economic prospects are seen as poor or challenging, or because existing debt obligations
are high and so the Board does not wish to increase them.
The Board of OAP Co may wish to follow a strategy of organic growth, financing capital investment projects from retained
earnings rather than seeking additional external finance.
The Board of OAP Co may wish to create an internal market for capital investment funds, so that capital investment proposals
must compete for the limited funds made available in the budget set by the Board. This competition would mean that only
robust capital investment projects would be funded, while marginal capital investment projects would be rejected.

2 (a) Inventory days = 365 x (5,700/26,000) = 80 days

Trade receivables days = 365 x (6,575/40,000) = 60 days
Trade payables days = 365 x (2,137/26,000) = 30 days
Working capital cycle of CSZ Co = 80 + 60 – 30 = 110 days
The working cycle of CSZ Co is positive and the company pays its trade suppliers 110 days (on average) before it receives
cash from its customers. This represents a financing need as far as CSZ Co is concerned, which could be funded from a
short-term or long-term source.
If the working capital cycle had been negative, CSZ Co would have been receiving cash from its customers before it needed
to pay its trade suppliers. A company which does not give credit to its customers, such as a supermarket chain, can have a
negative working capital cycle.
Even if companies might generally prefer to be paid by customers before they have to pay their suppliers, the question of
whether the working capital cycle should be positive or negative implies that companies are able to make such a choice, but
this is not usually the case. This is because the length of the working capital cycle depends on its elements, which are
inventory days, trade receivables days and trade payables, and these elements usually depend on the nature of the business
undertaken by a company and the way that business is conducted by its competitors. The length of the working capital cycle
is usually therefore similar between companies in the same business sector, but can differ between business sectors.

(b) At the end of March 2015:

Cost of sales = 40,000,000 x 0·6 = $24,000,000
Inventory using target inventory days = 24,000,000 x 60/365 = $3,945,206
Trade receivables using target trade receivables days = 40,000,000 x 75/365 = $8,219,178
Current assets = 3,945,206 + 8,219,178 = $12,164,384

12
 If the target current ratio is 1·4 times, current liabilities = 12,164,384/1·4 = $8,688,846
The target quick ratio (acid test ratio) = 8,219,178/8,688,846 = 0·95 times
Net current assets at the end of March 2015 = 12,164,384 – 8,688,846 = $3,475,538
Target sales/net working capital ratio = 40,000,000/3,475,538 = 11·5 times

(c) The current liabilities at the end of March 2015, calculated in part (b), can be divided into trade payables and the forecast
overdraft balance.
Trade payables using target trade payables days = 24,000,000 x 55/365 = $3,616,438.
The overdraft (balancing figure) = 8,688,846 – 3,616,438 = $5,072,408
Comparing current assets and current liabilities:
March 2014 March 2015
$000 $000 $000 $000
Inventory 5,700 3,945
Trade receivables 6,575 12,275 8,219 12,164
–––––– ––––––
Trade payables 2,137 3,616
Overdraft 4,682 6,819 5,072 8,688
–––––– –––––– –––––– ––––––
Net current assets 5,456 3,476
–––––– ––––––
The overdraft as a percentage of current liabilities will fall from 69% (4,682/6,819) to 58% (5,072/8,688). Even though
the overdraft is expected to increase by 8·3%, current liabilities are expected to increase by 27·4% (8,688/6,819). Most of
this increase is expected to be carried by trade payables, which will rise by 69·2% (3,616/2,137), with trade payables days
increasing from 30 days to 55 days.
At the end of March 2014, current liabilities were 56% of current assets (100 x 6,819/12,275), suggesting that 44% of
current assets were financed from a long-term source. At the end of March 2015, current liabilities are expected to be 71%
of current assets (100 x 8,688/12,164), suggesting that 29% of current assets are financed from a long-term source. This
increasing reliance on short-term finance implies an aggressive change in the working capital financing policy of CSZ Co.

(d) Transaction risk relates to foreign currency transactions which are short-term in nature, such as payments expected by a
company from foreign trade receivables, payments made by a company in settling foreign trade payables, and interest
payments made by a company on foreign currency-denominated debt. Transaction risk can be managed by several internal
methods.
Currency of invoice
One internal hedging method is for a company to invoice foreign customers in its domestic currency, thereby transferring the
foreign currency risk to the foreign customers. This method is usually not commercially viable, however, as foreign customers
will transfer their business to competitors who do invoice in the foreign currency, thereby avoiding the foreign currency risk.
Matching
The risk arising from foreign currency receipts and payments can be managed by matching. Receipts and payments in the
same foreign currency can be matched, for example, by using a foreign currency bank account, so that there is no need to
buy the foreign currency. Taking a longer-term view, assets and liabilities can be matched in order to hedge foreign currency
risk. For example, a company expecting regular foreign currency income can use debt in the same currency to meet a
financing need, so that the foreign currency interest on the debt can be met from the foreign currency income.
Leading and lagging
Transaction risk can be managed by leading and lagging, where foreign currency payments could be made in advance
(leading) or in arrears (lagging), depending on the view of the paying company as to whether the currency of payment was
expected to appreciate or depreciate against the domestic currency. Lagged payments to accounts payable should not exceed
the credit period agreed with the supplier, however.

3 (a) Cost of equity

The current cost of equity can be calculated using the capital asset pricing model.
Equity or market risk premium = 11 – 4 = 7%
Cost of equity = 4 + (0·9 x 7) = 4 + 6·3 = 10·3%
After-tax cost of debt
After-tax interest payment = 100 x 0·07 x (1 – 0·2) = $5·60 per bond
Year Cash flow $ 5% discount PV ($) 4% discount PV ($)
0 market value (107·14) 1·000 (107·14) 1·000 (107·14)
1–7 interest 5·60 5·786 32·40 6·002 33·61
7 redemption 100·00 0·711 71·10 0·760 76·00
–––––– ––––––
(3·64) 2·47
–––––– ––––––

13
 After-tax cost of debt = IRR = 4 + ((5 – 4) x 2·47)/(2·47 + 3·64) = 4 + 0·4 = 4·4%
Market value of equity = 10,000,000 x 7·50 =$75 million
Market value of Fence Co debt = 14 million x 107·14/100 = $15 million
Total market value of company = 75 + 15 = $90 million
WACC = ((10·3 x 75) + (4·4 x 15))/90 = 9·3%

(b) Since the investment project is different to business operations, its business risk is different to that of existing operations. A
cost of equity for appraising it can be therefore be found using the capital asset pricing model.
Ungearing proxy company equity beta
Asset beta = 1·2 x 54/(54 + (12 x 0·8)) = 1·2 x 54/63·6 = 1·019
Regearing asset beta
Market value of debt = $15m (calculated in part (a))
Regeared asset beta = 1·019 x (75 + (15 x 0·8))/75 = 1·019 x 87/75 = 1·182
Using the CAPM
Equity or market risk premium = 11 – 4 = 7%
Cost of equity = 4 + (1·182 x 7) = 4 + 8·3 = 12·3%

(c) Portfolio theory suggests that the total risk of a portfolio of investments can be reduced by diversifying the investments held
in the portfolio, e.g. by investing capital in a number of different shares rather than buying shares in only one or two
companies.
Even when a portfolio has been well-diversified over a number of different investments, there is a limit to the risk-reduction
effect, so that there is a level of risk which cannot be diversified away. This undiversifiable risk is the risk of the financial
system as a whole, and so is referred to as systematic risk or market risk. Diversifiable risk, which is the element of total risk
which can be reduced or minimised by portfolio diversification, is referred to as unsystematic risk or specific risk, since it
relates to individual or specific companies rather than to the financial system as a whole.
Portfolio theory is concerned with total risk, which is the sum of systematic risk and unsystematic risk. The capital asset
pricing model assumes that investors hold diversified portfolios, and so is concerned with systematic risk alone.

(d) Capital market efficiency is concerned with pricing efficiency when weak form, semi-strong form and strong form efficiency
are being discussed. In relation to pricing efficiency, the efficient markets hypothesis (EMH) suggests that share prices fully
and fairly reflect all relevant and available information. Relevant and available information can be divided into past
information, public information and private information.
Weak form efficiency
This form of pricing efficiency arises when share prices fully and fairly reflect all past share price movements. Past share price
movements cannot therefore be used to predict future share prices in order to make an abnormal gain and share prices appear
to follow a random walk, with share prices responding to new information as this arrives on the capital market.
Semi-strong form efficiency
This form of pricing efficiency arises when share prices fully and fairly reflect all relevant and available public information,
which includes all past information. Public information cannot therefore be used to make an abnormal gain, since capital
markets and share prices quickly and accurately respond to new information. Well-developed capital markets are held to be
semi-strong form efficient.
Strong form efficiency
This form of pricing efficiency arises when share prices fully and fairly reflect all private information as well as public
information. When capital markets are strong form efficient, no-one can make abnormal returns, even investors who possess
private or insider information. This level of pricing efficiency is not found in the real world, which is why governments legislate
against insider dealing.
Significance of EMH to financial managers
If the EMH is correct and share prices are fair, there is no point in financial managers seeking to mislead the capital market,
because such attempts will be unsuccessful. Window-dressing financial statements, for example, in order to show a
company’s performance and position in a favourable light, will be seen through by financial analysts as the capital market
digests the financial statement information in pricing the company’s shares.
Another consequence of the EMH for financial managers is that there is no particular time which is best for issuing new
shares, as share prices on the stock market are always fair.
Because share prices are always fair, there are no bargains to be found on the stock market, i.e. companies whose shares
are undervalued. An acquisition strategy which seeks to identify and exploit such stock market bargains is pointless if the
EMH is correct.
It should be noted, however, that if real-world capital markets are semi-strong form efficient rather than strong form efficient,
insider information may undermine the strength of the points made above. For example, a company which is valued fairly by
the stock market may be undervalued or overvalued if private or insider information is taken into account.

14
4 (a) Objective 1
MFZ Co has stated an objective to achieve growth in profit before interest and tax of 4% per year. Analysis shows that profit
before interest and tax growth was 3·4% in 2014 (18·3m/17·7m) and 3·5% in 2013 (17·7m/17·1m). MFZ Co has therefore
not achieved this objective in either year.
Objective 2
Year 2014 2013 2012
Profit after tax $12·8m $12·4m $12·0m
Number of shares 12m 12m 12m
Earnings per share 106·67c 103·33c 100·00c
Annual growth 3·2% 3·3%
MFZ Co has stated an objective to achieve growth in earnings per share of 3·5% per year. Analysis shows that growth in
earnings per share was 3·2% in 2014 (106·67c/103·33c) and 3·3% in 2013 (103·33c/100·00c). MFZ Co has therefore
not achieved this objective in either year.
Objective 3
MFZ Co has stated an objective to achieve growth in total shareholder return (TSR) of 5% per year. Analysis shows that growth
in TSR was 11·4% in 2014 and 11·7% in 2013. MFZ Co has therefore achieved this objective in both 2014 and 2013.
Year 2014 2013 2012
Equity market value $56·4m $55·2m $54·0m
Number of shares 12m 12m 12m
Share price $4·70 $4·60 $4·50
Dividends $5·1m $5·1m $4·8m
Number of shares 12m 12m 12m
Dividend per share 42·5c 42·5c 40·0c
On a per share basis:
2014 TSR = 100 x (470 – 460 + 42·5)/460 = 11·4%
2013 TSR = 100 x (460 – 450 + 42·5)/450 = 11·7%
Alternatively, using total values:
2014 TSR = 100 x (56·4m – 55·2m + 5·1m)/55·2m = 11·4%
2013 TSR = 100 x (55·2m – 54·0m + 5·1m)/54·0m = 11·7%

(b) Historical dividends per share have been 42·5c (2014), 42·5c (2013) and 40·0c (2012). There has therefore been zero
growth in dividend per share in 2014, 6·25% growth in dividend per share in 2013, and an average dividend growth rate
of 3·1% over the two-year period from 2012 to 2014. The same result could be found by considering total dividend paid
rather than dividend per share, since the number of shares has been constant over the two-year period. If historical dividend
per share growth is assumed to be an indication of future dividend per share growth, it seems reasonable to use a dividend
growth rate of 3·1% or zero in the dividend growth model (DGM).
Using zero future dividend growth, the 2014 share price using the DGM will be $3·54 per share (42·5/0·12) and the 2014
total equity market value will be $42·48m ($3·54 x 12m).
Using 3·1% dividend growth, the 2014 share price using the DGM will be $4·92 per share ((42·5 x 1·031)/(0·12 – 0·031))
and the 2014 total equity market value will be $59·04m ($4·92 x 12m).
The 2014 equity market value on the capital market is $56·4m. This is higher than the DGM value using zero future dividend
growth and lower than the DGM value using 3·1% dividend growth. One reason for the difference between the 2014 equity
market value and the values predicted by the DGM is that the capital market expects future growth in dividends to be different
from the assumed value used in the DGM, e.g. slightly less than 3·1%.
The future cost of equity of MFZ Co may also differ from the current cost of equity of 12% used in the DGM calculation and
the current market price may reflect an expectation of a future change in the cost of equity.

(c) Cash needed for investment = $9·2 million

Cash to be raised = $9·2m + issue costs = $9·2m + $0·2m = $9·4 million
Current share price = $56·4m/12m = $4·70 per share
Rights issue price = 4·70 x 0·8 = $3·76 per share
New shares to be issued = 9·4m/3·76 = 2·5 million shares
Total number of shares after issue = 12m + 2·5m = 14·5 million shares
Theoretical ex rights price = [(12m x 4·70) + (2·5m x 3·76) – 0·2m]/14·5m = $4·52 per share
Alternatively, theoretical ex rights price = ($56·4m + $9·2m)/14·5m = $4·52 per share

(d) There are a number of sources of long-term debt finance which may be available to a listed company such as MFZ Co, with
a variety of characteristics.

15
Long-term bank loan
MFZ Co could obtain the $9·2m which it needs for investment purposes via a bank loan, from either a single bank or from
a syndicate of banks. Interest payments on the bank loan could be annual, twice yearly or quarterly, and at either a fixed rate
or a floating rate of interest. Repayments of capital may be required along with interest payments and it is possible that a
constant cash amount would be regularly paid, with the amount of interest in the payment declining and the amount of capital
in the payment increasing over time. It is likely that the bank loan would be secured against particular non-current assets of
MFZ Co, so that the bank could recover its loan if the company defaults on interest payments.
Bonds or loan notes
Bonds or loan notes may be redeemable or irredeemable (permanent), although in recent years irredeemable corporate bonds
have been very rare. Fixed rate or floating rate interest is paid on the bonds, either annually or half yearly, with the interest
being based on nominal (par) value of the bonds rather than on their market value. Bonds, like ordinary shares, are mainly
traded on the capital markets and can be issued in a variety of foreign currencies. Redemption of a large bond issue can pose
a serious cash flow problem for a company and may call for refinancing rather than outright redemption. The return required
on debt finance (the cost of debt) is lower than the return required on equity (the cost of equity), and so MFZ Co could reduce
its average cost of capital by issuing debt finance, as it is currently financed by equity alone.
Convertible bonds or loan notes
Convertible bonds or loan notes are bonds which, at the option of the holder, can be converted into a specified quantity of
ordinary shares (the conversion ratio) on a specified future date (the conversion date). They have the advantage for the issuing
company that, assuming conversion terms are set appropriately, conversion will occur and so redemption can be avoided. If
conversion occurs, there can be a significant reduction in the gearing of the issuing company. The future option to convert
into equity has value to investors and as a consequence, the interest rate on convertible debt is lower than that on ordinary
bonds. Convertible bonds can pay interest annually or twice annually, at a fixed or a floating rate of interest. If conversion
does not take place, however, redemption of the bonds or loan notes will be required.
Deep discount bonds and zero coupon bonds
The return to a bond holder consists of regular interest payments (income) and repayment of the principle amount on
redemption (capital). Investors may accept lower interest payments (lower income) in exchange for an increase in capital
return. This can be achieved if the bond is issued at a deep discount to nominal value, but redeemed at nominal value. This
kind of financial security is called a deep discount bond and may be suitable for companies which do not expect an immediate
return on invested capital. A zero coupon bond goes a step further and pays no interest (coupon) at all, so that the return to
the investor is entirely in the form of capital appreciation. Bonds like these are useful for companies which expect cash flows
from invested capital to occur mainly later in the life of an investment project, rather than more evenly throughout its life.

16
Fundamentals Level – Skills Module, Paper F9
Financial Management June 2014 Marking Scheme

Marks Marks
1 (a) Sales income 1
Inflation of sales income 1
Variable cost 1
Inflation of variable cost 1
Inflated fixed costs 1
Tax liability 1
Timing of tax liability 1
Tax allowable depreciation years 1 to 3 1
Balancing allowance 1
Tax allowable depreciation tax benefits 1
Scrap value 1
Calculation of present values 1
Calculation of NPV 1
Comment on financial acceptability 1
––––
14

(b) Calculation of profitability indices 1

Ranking by profitability indices 1
Allocation of funds to Project E 1
Calculation of pro rata NPV on partial project 1
Calculation of maximum NPV 1
––––
5

(c) Reasons for not raising equity finance 2–3

Reasons for not raising debt finance 2–3
Other relevant discussion 1–2
––––
Maximum 6
–––
25
–––

17
 Marks Marks
2 (a) Inventory days 0·5
Trade receivables days 0·5
Trade payables days 0·5
Working capital cycle 0·5
Discussion of working capital cycle 4
––––
6

(b) Cost of sales 0·5

Inventory 0·5
Trade receivables 0·5
Current assets 0·5
Current liabilities 0·5
Target quick ratio 1
Net working capital 0·5
Target sales/net working capital ratio 1
––––
5

(c) Trade payables 1

Overdraft 1
Analysis of current asset and liability positions 1–3
Comparison of current asset and liability positions 1–3
Discussion of change in financing policy 1–3
––––
Maximum 8

(d) Transaction risk 1

Currency of invoice 1–2
Matching 1–2
Leading and lagging 1–2
––––
Maximum 6
–––
25
–––

3 (a) Calculation of equity risk premium 1

Calculation of cost of equity 1
After-tax interest payment 1
Setting up IRR calculation 1
Calculating after-tax cost of debt 1
Market value of equity 0·5
Market value of debt 0·5
Calculating WACC 1
––––
7

(b) Ungearing proxy company equity beta 2

Regearing equity beta 1
Calculation of cost of equity 1
––––
4

(c) Risk diversification 1–2

Systematic risk 1–2
Unsystematic risk 1–2
Portfolio theory and the CAPM 1–2
––––
Maximum 6

(d) Nature of capital market efficiency 1–2

Weak form efficiency 1–2
Semi-strong form efficiency 1–2
Strong form efficiency 1–2
Significance of EMH for financial manager 2–3
––––
Maximum 8
–––
25
–––

18
 Marks Marks
4 (a) Calculations of PBIT growth 1
Comment on PBIT growth 1
Calculations of EPS growth 1
Comment on EPS growth 1
2014 total shareholder return 1
2013 total shareholder return 1
Comment on TSR growth 1
––––
7

(b) Calculation of historical dividend growth rate 1

Total equity market value using DGM 2
Discussion of DGM value and equity market value 2
––––
5

(c) Cash to be raised 1

Rights issue price 1
New shares issued 1
Theoretical ex rights price per share 2
––––
5

(d) Long-term bank loan 1–2

Bonds or loan notes 1–2
Convertible bonds or loan notes 1–2
Deep discount bonds and zero coupon bonds 1–2
Other relevant discussion 1–2
––––
Maximum 8
–––
25
–––

19